It should also be noted that payment to creditors can only be made if debtors pay on time. Should debtors not pay on time the company would be unable to pay off its creditors which could result in possible liquidity difficulties, therefore having a knock-on-effect on the whole of the business operations.
Cutting or delaying expenditure: Ways of decreasing expenditure include:
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Decreasing levels of stock: often cash flow problems arise because too much capital is tied up in stock. When we talk about stock we mean raw materials, work-in-progress and finished goods. Many firms are now implementing practices such as Just-in Time, and Kan Ban, which are designed to reduce capital tied up in stock and allow it to be used in more effective ways within the business;
- Cutting costs;
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Postponing expenditure: extending a credit period will help short term cash flow, this could be done by delaying paying bills for an extra 30 days, meaning there will be more cash in the bank for this period. Unfortunately this type of action may upset the businesses suppliers, after all they have their own cash flows to think of.
Finding additional funding to cover cash shortages: This can be done by:
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Using an overdraft - an overdraft is arranged with a bank. It allows the business to overdraw up to an agreed limit negotiated in advance. Overdrafts usually incur high rates of interest. As much as 6% - over base rate. An overdraft ensures the business only borrows money on the days it really needs it. It is a very flexible form of borrowing. This makes it suitable for small or short-term shortages of cash. Although it should only be used to fund short-term problems. A risky aspect of an overdraft is that the bank can withdraw the facility at any time and demand instant repayment. So, when a business needs it most, such as in a recession, it may find the bank has withdrawn it. The business could obtain an overdraft in order to substitute the negative bank balance in the month of May.
The business is showing a positive cash flow throughout the financial year, apart from the month of May when there is a negative balance due to the bank loan being repaid in full. The business could clearly finance the bank loan repayments via its current practices and use a wide range of actions mentioned to help reduce the negative cash flow in the month of May.
If the business was to reduce the credit period to its customers in order to subsidise payment for the bank loan in full, this policy will result in a loss of goodwill and problems with customers and even loss of trade. Obtaining further finances to cover the negative cash flow balance in the month of May, such as an overdraft would result in the business having further liabilities and having to pay unnecessary interest charges on the amount borrowed. The business would end up paying far greater than the other latter options.
Therefore, the most viable option the business should select in order to finance the bank loan repayment would be to spread the cost of repayments throughout the budget year and thus avoid the negative cash flow balance in the month of May.
This way the company would not have to change any of its current practices or borrow any further cash from external sources and pay unnecessary interest in addition to admin charges in the event of late payment.
Scenario 2
The owner of the Rembrandt Restaurant has produced the following budget information at the end of her financial year:
Last year’s Budget
Sales £
Meals 600,000 (40,000 meals)
Wine sales 200,000 (20,000 bottles)
Costs
Food 120,000
Wine 100,000
Catering Staff 100,000 (5 chefs )
Waiters 100,000 (10 staff)
Fixed Costs 250,000
Total Costs 670,000
Net Profit 130,000
Other information:
- One chef produces 8,000 meals per annum.
- One waiter/waitress is required for 4,000 customers per annum.
- The material/food cost per meal is £3.00.
Selling prices have been adjusted to allow for inflation based on the retail price index but had not adjusted costs. The index for the year prior to the budget was 120 and the budget year was 123.6.
The actual results for the year were:
Sales £
Meals 700,000 (46,000 meals)
Wine sales 200,000 (23,000 bottles)
Costs
Food 142,200
Wine 120 200
Catering Staff 123,600
Waiters 125,400
Fixed Costs 254.500
Total Costs 765,900
Net Profit 134,000
The profit is less than expected.
Flexible Budget
Definition: A flexible budget is a budget that is a function of one or more levels of activity. Thus, the budget depends on one or more measures of activity volume rather than being fixed in amount.
Purpose: The purpose of a flexible budget is to develop an estimate or estimates of cost for one or more levels of activity. Activity levels are typically measured in terms of activity inputs, levels, or outputs. Such a budget is flexible in the sense that it depends upon a specified level of activity volume.
Common uses of flexible budgets include:
1. To estimate total indirect factory costs at different levels of activity to compute budgeted activity cost rates,
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To budget total indirect factory costs at different levels of activity to compute standard activity cost rates,
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To estimate total activity costs at different levels of activity to compute budgeted or standard activity cost rates.
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To estimate total activity cost for the level of activity achieved for control and performance evaluation purposes,
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To forecast total activity costs for cash budgeting purposes,
6. To forecast activity costs for expense budgeting purposes, and
7. To forecast total activity costs to forecast earnings under different scenarios.
The master budget, as company policy, is a fixed budget and will have been based on forecasts and predictions of sales at a certain level of activity, with the resulting costs incurred applicable to that level of sales. It is a fact of life, however, that budgets are not always achieved: sometimes sales are more than expected, sometimes less.
Comparisons of costs and revenue between the fixed budget, set at one level of output, and the actual results achieved at a different level, will therefore not be able to be made with ease. This is because of the behavioural nature of costs. Fixed costs, of course, could be compared, for they would not be expected to change in line with the changes in activity. But variable costs will, as they are deemed to have a linear relationship with sales.
To recognise this fact flexible budgets are often used. To achieve this, the fixed budget costs need to be analysed between fixed costs and variable costs, using marginal costing techniques. Actual costs incurred will also be analysed by cost behaviour. Then, using the actual sales units as the driver, the fixed budget will be reworked at the actual level of sales achieved. The budgeted variable costs will reflect the actual units sold; the fixed costs will stay the same as the original budget.
Revised Flexible Budget
Flexible Budget: Rembrandt Restaurant
Variable Unit (£) £ 000 £000
(spare capacity) (no spare capacity)
Sales
Meals 15.00 690,000 690,000
Wine 10.00 230,000 230,000
Costs
Food 3.11 143,060 143,060
Wine 5.18 119,140 119,140
Catering Staff 20,000 (6 Chefs) 120,000 115,000
Waiters 10,000 (12 Waiters) 120,000 115,000
Fixed Costs 250,000 250,000
Total Costs 752,200 742,200
Net Profit 167,800 177,800
Notes:
Original Budget: 40,000 Meals
20,000 Wine Bottles
Actual Budget: 46,000 Meals
23,000 Wine Bottles
Flexible Budget: 46,000 Meals
23,000 Wine Bottles
Unit selling prices were calculated as follows:
Meals = Sales £600,000 / 40,000 Meals = £15.00 Selling prices have been
Wine = Sales £200,000 / 20,000 Bottles = £10.00 adjusted to allow for inflation
Total Flexible Budget Sales:
Meals = 43,000 * £15.00 = £690,000
Wine = 23,000 * £10.00 = £230,000
Unit cost prices were calculated as follows:
Food = Cost £120,000 / 40,000 Meals = £3.00 Selling prices have not been
Wine = Cost £100,000 / 20,000 Bottles = £5.00 adjusted to allow for inflation.
Adjustments to allow for inflation:
Increase in inflation = Index prior to budget year: 120
Index for budget year: 123.6
Increase in inflation = 3.6%
Food cost per unit adjusted with inflation = 3.6 * £3.00 / 100 = 0.108
+ 3.00
Food cost per unit (£) 3.108 (£3.11)
Wine cost per unit adjusted with inflation = 3.6 * £5.00 / 100 = 0.18
+ 5.00
Wine cost per unit (£) 5.18
Total Flexible Budget Costs:
Food = 46,000 Meals * £3.10 Unit cost = £143,060
Wine = 23,000 Bottles * £5.18 Unit cost = £119,140
Unit costs for labour:
One chef produces 8,000 meals per annum
Catering staff: 5 chefs = £100,000 / 5 = £20,000 per chef
One waiter/waitress is required for 4,000 customers per annum
Waiters: 10 waiters = £100,000 / 10 = £10,000 per waiter
Total Flexible Budget Costs:
Catering staff: 46,000 Total Meals / 8,000 Meals = 5.75 = 6 chefs * £20,000
£120,000
Thus leaving a spare capacity up to the next threshold of 48,000 meals
Without any spare capacity the calculation would be as follows:
Catering staff: 46,000 Total Meals / 8,000 Meals = 5.75 * £20,000
£115,000
5 chefs would be employed for the full budget year and 1 would be employed for 3 quarters of the budget year (9 months).
Waiters: 46,000 Customers / 4,000 Customers = 11.5 = 12 waiters * £10,000
£120,000
Thus leaving a spare capacity up to the next threshold of 48,000 customers.
Without any spare capacity the calculation would be as follows:
Catering staff: 46,000 Customers / 4,000 Customers = 11.5 * £10,000
£115,000
10 waiters would be employed for the full budget year and 1 would be employed for 2 quarters of the budget year (6 months).
Fixed Costs:
Fixed costs are not expected to change in line with the changes of activity and will therefore remain static irrespective of any changes in activity.
Variance Analysis
In each accounting period, actual results will be compared with the budget, and budget variances arrived at. This is the difference between the actual results and the equivalent budget figures. Variances enable ‘management by exception’ techniques to be operated so that management need look at those areas of performance and activity which are out of line with the budget. They therefore have more time available to deal with the problems and opportunities thrown up by the figures.
It is important to note that variances are referred to as adverse or favourable – not positive or negative. A favourable variance is one which leads to higher than expected profit (revenue up or costs down). An adverse variance is one which reduces profit.
Variance Analysis: Rembrandt Restaurant
Variable Flexed Budget Actual Results Budget Variances
Sales
Meals 690,000 700,000 10,000 F
Wine 230,000 200,000 30,000 A
Costs
Food 143,060 142,200 860 F
Wine 119,140 120,200 1,060 A
Catering Staff 120,000 123,600 3,600 A
Waiters 120,000 125,400 5,400 A
Fixed Costs 250,000 254,500 4,500 A
Total Costs 752,200 765,900 13,700 A
Net Profit 167,800 134,000 33,800 A
Note:
Favourable = F
Adverse = A
The flexible budget with spare capacity has been employed for the variance analysis.
Comments on the Analysis
Sales in meals had a favourable variance, an increase of £10,000. This was due to the increase in the selling price per meal by £0.22 from £15.00 to £15.22. The increase in selling price could have been as a direct result of costs in producing per meal increasing.
Food costs also had a favourable variance, a decrease of £860.00, resulting from the reduction in purchase costs per meal by £0.02 from £3.11 to £3.09 per meal. Discounts on bulk purchases may have been received or supplies may have been purchased form an alternative supplier at a more competitive price. It’s also possible that much greater care has been taken in preparing meals and purchasing quality supplies thus limiting the amount of wastage.
Wine sales had an adverse variance, a difference of £30,000 resulting from the decrease in the selling price per bottle by £1.31 from £10.00 to £8.69 per bottle. The reduction in price could have resulted as a result of less consumer demand due to a change in consumer tastes or to attract new market segment or new customers.
Wine costs also had an adverse variance, an increase of £1,060.00 from £119,140 to £120,200. This was a direct result of the increase in purchase costs per bottle from £5.18 to £5.22 per bottle. It’s possible that their could have been a change in quantity purchased thus reducing the amount of discounts allowed or that suppliers had increased their selling price per bottle. It’s also possible that their may have been a change in the type of wine purchased. If the wine was imported, it’s possible their could have been a movement in currency.
Catering staff costs had an adverse variance, an increase in costs of £3,600 from £120,000 to £123,600. One chef produces 8,000 meals per annum and a total of 6 chefs were required, based on a spare capacity up to the next threshold.
Costs per chef had increased by £600 per annum from £20,000 to £20,600. The increase could have been due to an increase in wages. It’s also possible that each chef was unable to produce the required amount of meals due to poor morale/working conditions or a change in working methods thus resulting in the introduction of overtime or even another chef being employed.
Waiter’s costs also had an adverse variance, an increase in costs of £5,400 from £120,000 to £125,400. One waiter is required for 4,000 customers per annum and a total of 12 waiters were required, based on a spare capacity up to the next threshold.
Costs per waiter had increased by £1,400 per annum from £10,000 to £11,400. The increase could have been due to an increase in wages. It’s also possible that more than 1 waiter was required for every 4,000 customers due to poor morale/working conditions or a change in working methods thus resulting in the introduction of overtime or even another waiter being employed.
Fixed costs had an adverse variance, an increase of £4,500 from £250,000 to £254,500. This could have been as a direct result in the change of fixed overheads, e.g. rent, rates and standing charges.
In selling 46,000 meals and 23,000 wine bottles the expected costs should have been £752,200. Instead, actual costs were £765,900 i.e. £13,700 higher than had expected. The reason for the increase being that costs were much higher than expected.
Net profit had an adverse variance of £33,800, mainly due to the increase in costs and the decrease in sales revenue from wines.
Incremental v Zero Budgeting
Incremental based budgeting is an approach whereby firms treat last year’s budget figures as the main determinant of this year’s budget. Minor adjustments will be made for inflation and other foreseeable changes. It is very unlikely that budgets will fall if this method is being used. The great advantage of this method is that very little time needs to be spent on the budget setting task.
The advantages of incremental budgeting are that it is less time consuming and it may be the best method for budgeting basic cost items. The disadvantages of incremental budgeting are that:
- it assumes that all current functions should be continued in their present form, and therefore carries forward all the current weaknesses, as well as strengths.
- it assumes that performance in the current period is a reasonable basis for predicting the future regardless of any positive or negative factors (external or internal) that may have affected the current performance.
- it makes no attempt to assess what the potential is.
Zero based budgeting is an approach which sets each department’s budget at zero and demands that budget holders, in setting their budget, justify every amount they ask for. This helps to avoid the common phenomenon of budgets creeping upwards each year. The advantages and disadvantages of this method are set out below:
Advantages of zero budgeting:
- Helps to identify those departments that no longer need as large a budget. This can release funds for growth areas elsewhere within the organisation.
- Can work effectively as a way of cutting the entire cost base of the organisation. This may be necessary in times of recession.
Disadvantages of zero budgeting:
- In order to justify every pound of every budget, a great amount of management time is spent on the budget setting process. This time could be used, perhaps more effectively, elsewhere.
- Fails to overcome the age-old problem that some managers are more devious than others in trying to justify a larger budget than is really needed.
The best criteria for setting budgets are:
- To be clear about the firm’s objectives and the strategy for achieving them. Departments with a key role to play in achieving objectives might expect an increase in the year’s budget. Departments where no extra activity is required can expect their budget to be frozen, or perhaps cut back a little to release funds.
- To involve as many people as possible in the process. People will be more committed to reaching the targets if they have had a say in how the budget was set.
- To make the process as transparent as possible, so that everyone knows how decisions are reached.
Recommendation
When setting budgets it is often the practice to see what happened in the pre-budget year and, using this as the base, simply add extra costs to those figures, perhaps as a straight percentage increase to that year’s actual costs. This is a common budget approach by Rembrandt Restaurant. This method of budgeting carries with it the likelihood of past excesses and inefficiencies being carried forward and added to from one year to the next, thus effectively projecting these negatives into the future as self-perpetuating routines.
The technique of zero based budgeting takes the view that every item of expenditure incurred in an activity needs to be re-valuated and reassessed from the beginning when a budget is being prepared. The previous year’s results are thereby effectively ignored.
Each expenditure heading starts from ‘£0’: the zero base; each component of cost created by the activity is evaluated and justified, and the budget for the expenditure heading is thus built up. Thus every part of the activity that generates cost will be analysed and alternative methods for completing each will be considered and evaluated.
Zero based budgeting can therefore take a long time to complete, with each and every activity needing to be broken down and the alternatives considered, costed and justified, with the budget slowly built up using the best considered alternatives and clearly a much better suited approach which should be adopted by Rembrandt Restaurant. Also with zero based budgeting the spare capacity consuming additional costs would have been eliminated.
There are several advantages to Rembrandt Restaurant in employing zero-based budgeting. It better equips management to make decisions when comparing actual program performance to the budget. Zero-based budgeting most often gives a better estimate of revenue projections and helps create a model for spending by breaking the habit of budgeting non-essential costs simply because they were incurred the prior year. The disadvantages of zero-based budgeting are that it is time-consuming and some categories in the budget are best estimated based on historical data because they are difficult to calculate from zero. For example, the cost of general supplies may best be calculated by examining existing data for historical usage combined with the projected rate of inflation.